Relative Valuation

Comparative analysis

Relative valuation is stock valuation method that gained its popularity because of simplicity and practical importance. The key principle of relative valuation is about valuation multiples that have to be calculated for the assessed stock and for similar companies. Then calculated ratios must be compared in-between identifying most attractive ones.

For example, if you are looking for stocks to invest then you simply choose one industry niche in the region that you want and try collect as many listed companies according to your criteria as you can handle. Then you need to calculate multiples for selected companies and try to find ones that have lowest multiples.

Calculation of the multiples isn’t yet everything. You also have to make full analysis of the selected companies: to find main differences between them if such differences would impact changes in future results.

Only when you know the multiples and the main differences between companies, you may say which stocks are the most attractive for investing, however, relative valuation may show results only for one sector. It is very hard to compare companies from different segment or different markets, because it is natural that different companies have various multiples.

Which Multiples to Choose for Relative Valuation

There are many multiples that might be used in relative valuation, so how to choose the best one? The answer is not convenient. There is no best one. All the ratios have some meaning and in one case one ratio may be the most important while in other case another ratio will more meaningful.

If you are analyzing standard company, which has average profitability margins in the industry group, then you should focus on two ratios: P/E and EV/EBITDA. Usually if one of those is very attractive another will look good too. But it does not have to be necessary so. However, if any of those ratios is very low (if sustainable and calculated correctly) compared to competitors, it is a good sign. EV/EBITDA is better for international comparison and for companies in emerging markets, where financial results are less stable. Also EV/EBITDA is very good ratio for those companies that might be a target of acquisition, because this ratio plays the main role in M&A and corporate finance.

P/E ratio is often criticized by professionals, because net earnings are very dependable on accounting policy and may be manipulated. And this is true. That is why you have to trust this ratio very carefully. But this doesn’t mean that P/E ratio is a bad ratio. Actually, P/E is the most complete valuation multiple, but only if applied on companies that are stable and in a stable environment, accounting policy is standard and there are no effects of one-offs or discontinued operations. To get such high quality P/E calculated is not a bit easier than calculate EV/EBITDA. P/E ratio also requires additional attention to capital structure (higher financial leverage means higher risk).

But if company is unprofitable (even if EBITDA margin is positive, it may be too low and do not represent potential profitability) P/E, EV/EBITDA and similar ratios are useless, because they are based on earnings. If there are no normal earnings, we have to look for other ratios.

Such ratios might be EV/S, P/B or other specific ratios. P/B ratio might show some value if is lower than 1 significantly and if company’s assets are close to real market value. EV/S ratio often might be the last option for unprofitable companies, but if you want to use this ratio, you have to analyze company and the market to be sure that there is potential for profitability increase in the future.

Other specific ratios may be applied in some cases. For example, for unprofitable mining companies owned resources might be compared in form EV/resources (in tones).

For banks mainly two market ratios are used: P/E and P/B. However, you have to use P/B carefully if this ratio is high or financial markets are in turmoil, because then balance sheet numbers might not reflect real value of the assets correctly. Also it is not the problem for company to boost equity with new funds, and if bank does that often, you should not give too much weight to P/B ratio.

For fast growing companies PEG ratio might be useful. Of course, company has to be profitable and sustain stable growth ratio to use PEG.

For real estate companies, holding companies or other asset-based companies the best ratio is P/NAV. Most of the times when valuating such companies P/NAV is the only option to get some true opinion about investment. Assets (for NAV calculation) must be valued at real market values.

How to Calculate Valuation Multiples

Calculation of multiples is simple for experienced investors, but might be the challenge for beginners. For those who doesn’t have yet enough experience in these calculations, the suggestion would be to try calculate ratios for some bigger companies and to find those ratios calculated by professionals, if they do not match, look for problems.

How to Choose Companies for Comparison

This part looks very easy, but many investors including professionals do mistakes when selecting companies for comparison. The first thing in this process is to find companies in similar environment. Two main factors are influencing that: industry niche and region. Industry niche must be the same, which means offered products or services of the compared companies must be very similar. Region has to be the same or identical (with similar economic characteristics and risks).

It would be perfect if inner characteristics of the compared companies also would match. Such inner characteristics could be: growth rate, size, market share, attitude to shareholders, profitability margins, capital structure, management quality, dependence on main clients and many others.

The best way to find companies for comparison is to look for direct competitors. The more companies for comparison the better but if you will find 5 to 10 companies it is okay.

How to Offset the Differences in Relative Valuation

Often you will not find identical listed companies for comparison doesn’t matter how hard to try. In such cases you should find the most similar companies. All the main differences may be described by two characters: grow rate and risk.

So if compared companies have differences you should predict grow rate of each. And if growth rate is different, you should compare not current ratios (or ratios with trailing results) but use forecasted multiples, for example, three years forward.

Risk is influenced by various factors, and most of the times, stocks represent different risk levels. If you see that selected companies maintain different risk, you should calculate capital cost and adjust business valuation multiples according to cost of capital. Equity multiples (as P/E, P/B) should be adjusted according to equity cost of capital, and the enterprise multiples (as EV/EBITDA, EV/S) should be adjusted according to weighted average capital costs (WACC).

Price over Quality

When you buy something on the store you look at the price, but not only at the price. Also you are thinking about the quality of the item. If you think that item is worth the price and you need it, you buy it. The same is with stock. Valuation multiples show only the price of the stock, so if the stock is worth the price and you have free cash – you buy it.

Valuation multiples (as P/E and EV/EBITDA) may help us to find cheap stocks, but they will not give an answer if the stock is worth investing. You have to analyze the target company comprehensively, to find its weaknesses and strengths. When you are sure about the company’s future, you will know about the quality of the company. Then you have to compare it to the price (multiples) and decide if the quality is worth asked price. If yes, that means it is a good investment according to you and you should include those shares in your investment portfolio.

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